Exploring Good Debt vs. Bad Debt
One of the most frequently asked questions I get about money is: “Should I pay off X debt or save my money?” Before I give advice, there are a few questions I’ll ask.
Is the debt “good debt” or “bad debt”?
“Good debt” would be classified as home loans, student loans, 0% credit cards, etc. Either a loan that has a tax deductibility or no interest. “Bad debt” would be considered car loans, unsecured loans, and credit card debt that has a high interest rate.
What type of emergency fund do you have set up?
If you have a $0 emergency fund, of course I’m going to tell you to save it!
How is the economy at this moment?
Personally I feel that if the economy is bad, I’d rather save my money and have that cash available to pay for living expenses. If you pay off the debt instead, you may find yourself strapped for cash.
A few weeks ago, a friend asked me for some advice. She said that she and her husband took out a car loan and they were going to try to pay it off as soon as possible. Now, I asked her what kind of emergency fund they had. I also suggested that they think about the current state of the economy right now, and how horrible it is. She told me their current financial situation; her husband is employed, she’s a full time student with no income, they have two young children, and small savings. I asked her what the interest rate on the loan was. 6.25%, not too bad.
I then made the suggestion that instead of paying off that debt as soon as possible, that they put any money aside that they were going to put towards that loan and put it in a high yield online savings account. That way, if they ever became desperate for money, they’d have it there as their emergency fund. If they’d used that money and paid on the loan they wouldn’t have anything. Of course at the same time, they need to not scrimp on retirement, especially if the husband’s employer does a matching contribution. I know that a lot of financial advisers recommend paying off debt first, but I think it’s very important to have that emergency fund as well. Of course, if the debt that you have bothers you, and it’s better for your peace of mind to pay off that debt as fast as you can, then by all means throw your money towards that loan. It’s all about what makes you comfortable. Some people are comfortable with having $1,000 in savings, whereas others have to have $10,000 in savings, even if they have debt. It’s all about a comfort level. Do what you feel is right.